Recovery Proceedings against Guarantors during the Insolvency of the Principal Debtor

[Milind Gaur is a 5th Year BBA LLB student of Symbiosis Law School, Pune.]

Introduction

With the dawn of the Insolvency and Bankruptcy Code, 2016 (the Code), a crucial and much needed framework was set in place for tackling the insolvency and bankruptcy regime in India. At the same time, the Code has elicited clarifications and interpretation across various provisions. One such question which arose recently relates to the “recovery proceedings against the guarantors of a corporate debtor during the corporate insolvency resolution process (CIRP) of the corporate debtor”. In simpler terms, the question pertained to whether separate proceedings can be initiated or continued against the guarantors of a corporate debtor undergoing a CIRP.

Judicial Views

Views of the NCLT and the NCLAT

In an appeal against judgement of National Company Law Tribunal (NCLT), Mumbai Bench, in the case of Alpha & Omega Diagnostics (India) Ltd. v. Asset Reconstruction Company of India Ltd. & Ors. (31 July 2017), the National Company Law Appellate Tribunal (NCLAT) settled the question with regard to treatment of properties of the guarantors during a moratorium under section 14 of the Code. In this case, the personal properties of the promoters had been given as security to the banks. The question before the NCLT Mumbai was whether such properties that are not owned by the corporate debtor would fall within the ambit of a moratorium under the Code. 

Applying the principle of strict interpretation, the NCLT Mumbai held that the term “its” under section 14(1)(c) of the Code refers to the property of the corporate debtor undergoing a CIRP. Accordingly, the property not owned by the corporate debtor would not fall within the ambit of the moratorium imposed under the Code. Upholding the decision of the NCLT, the NCLAT held that the moratorium would not be applicable to any assets, movable or immoveable, that do not belong to the corporate debtor.

Therefore, both the NCLT and the NCLAT had decided the issue strictly interpreting the Code, and holding that it is only the property of the corporate debtor that would fall within the shadow of the moratorium imposed under section 14(1)(c) and no other properties shall be covered thereunder.

A similar question arose before the NCLT Mumbai in the case of Schweitzer Systemtek India Private Limited v. Phoenix ARC Private Limited (3 July 2017). The petition was filed by Schweitzer Systemtek India, invoking the Code before the NCLT under section 10, after it defaulted on a loan of Rs. 4.5 crore given by Dhanlaxmi Bank. The suit was initiated by the promoter himself against the Phoenix Asset Reconstruction Company, to which the said loan had been assigned by Dhanlaxmi Bank.

The NCLT Mumbai observed that the moratorium has no application on the properties beyond the ownership of the corporate debtor, and thus a personal guarantor of an insolvent company will be liable to pay his dues. The NCLT Mumbai asked for the personal properties of promoters to be auctioned off even when the CIRP was pending before the insolvency professional.

In this particular ruling too, the NCLAT relied on a strict interpretation of the Code and issued the order (on 9 August 2017) in line with its order in the Alpha & Omega Diagnostics (discussed above). The NCLAT held that only the properties owned by the corporate debtor shall be covered within the moratorium imposed under section 14 of the Code. Thus, proceedings for recovery from the corporate debtor under the Code would in no way be a hindrance to any recovery proceeding against the guarantor.

With both these rulings in purview, it was clearly established that since an action against the properties of a guarantor are not covered under the moratorium imposed on the corporate debtor, the proceedings against the guarantor for recovery of guarantee amount can be initiated or continued, despite the moratorium on legal proceedings in other forums against the corporate debtor during its CIRP.

Allahabad High Court’s View

In the case of Sanjeev Shreya v. State Bank of India, the Allahabad High Court provided for a restraint on the rights of the creditors to institute parallel proceedings against guarantors of the corporate debtor undergoing a CIRP.

The Allahabad High Court stated that a corporate debtor’s liability under the CIRP only crystallizes once the NCLT approves the resolution plan under section 31(1) of the Code or passes an order for liquidation of the corporate debtor under section 33 of the Code. The Court held that until the liability of the company is decisively crystallized, the guarantors cannot be held liable and as such the recovery proceedings against the guarantors before any other legal forum like the Debt Recovery Tribunal should also be covered under a moratorium. Creditors cannot be granted the right to pursue two parallel remedies for a same cause of action. In simpler terms, the Allahabad High Court held that proceedings against guarantors of the corporate debtor cannot be continued while the moratorium issued under section 14 of the Code is in force.

With this judgement of the Allahabad High Court, the position established previously through the NCLAT judgements discussed above stands altered, and by that the creditors would not have the right to proceed for recovery against the guarantors of a corporate debtor undergoing a CIRP, until the time the moratorium (under section 14) of the Code is in place.

Analysis

Given the different outcomes emanating from the NCLT and NCLAT on the one hand, and the Allahabad High Court on the other, I now analyze some scenarios for a finer comprehension of the issues involved.

Scenario 1

If recovery proceedings are allowed during the moratorium period and the creditor recovers its dues from the guarantor:

1. After the satisfaction of the guarantee, the guarantor will have the right to recover the amount from the corporate debtor.

2. The creditor will have to be excluded from the CIRP process of the corporate debtor, since the amount due to it will be satisfied by the guarantor. A creditor cannot be allowed to claim both the guarantee amount and amount under the CIRP of the corporate debtor.

3. If dues of the creditor are partially paid by the guarantor, then both creditor and the guarantor would have a claim on the recovery proceeds under CIRP to their respective amounts.

Some light was thrown on such a scenario by the NCLT’s Chennai’s bench in the case of Mr. V. Ramakrishnan v. M/s. Veesons Energy Systems Pvt. Ltd. And State Bank of India (18 September 2017). The NCLT had ordered the initiation of insolvency proceedings against Veesons Energy Systems Pvt. Ltd., and State Bank of India (SBI), one of the majority creditors, submitted its claim after the CIRP was initiated. The promoter and managing director, Mr. V. Ramakrishnan, had given a personal guarantee for the SBI loan. SBI had initiated action to the sell the assets of the promoter given as personal guarantee. Mr. Ramakrishnan moved the NCLT against the action of SBI.

The promoter’s contention was that since the corporate insolvency resolution process was underway, the personal assets sold by the financial creditor, SB,) should give him equal rights as that of the creditors and automatically create a right in his favor on the property of the corporate debtor which is under the insolvency process.

The NCLT ruled in favor of Mr. Ramakrishnan and offered the reasoning that in case a guarantor’s personal property is sold to realize the dues from the principal debtor during the moratorium period of the principal debtor, then the guarantor would have a charge upon the property of the principal debtor for recovering such amounts. Thus, a charge on the assets of the principal debtor would be created in favor of the guarantor, during the continuance of the moratorium period, which is prohibited.

The Code under section 14 states that when a moratorium is in effect and the company is going through an insolvency proceeding, the corporate debtor is not permitted to transfer, encumber, alienate or dispose of any of its assets or any legal right or beneficial interest therein. Thus, if a guarantor pays the guaranteed amount to the creditor, he shall have a right to recover such amounts from the principal debtor, in this case the corporate debtor. If the creditor proceeds and recovers the guaranteed amount from the guarantor while the moratorium period under CIRP is in force, then, during the moratorium period itself, the guarantor will obtain a charge over the corporate debtor’s assets (equivalent to the amount of guarantee amount paid). However, as aforementioned, the creation of any such charge /encumbrance over the assets of the corporate debtor is prohibited until the time the moratorium is in force under section 14.

Therefore, this ruling by the NCLT favors the scenario wherein no recovery proceedings can be initiated against the guarantor of a corporate debtor, until the time the moratorium is in force.

Scenario 2

Under this scenario, which needs a fresh look, a creditor is within its rights to claim from the guarantor to the extent of an unsatisfied claim under the CIRP. If recovery from the guarantor is carried out after the moratorium period, it would lead to major complications because, as aforementioned, the creditor cannot be allowed to claim both from the guarantor and the corporate debtor.

The moratorium of the Corporate Debtor will be lifted only after a resolution plan under section 31(1) of the Code is passed or an order for liquidation of the corporate debtor is issued under Section 33 of the Code.

Thus, if the creditor is allowed to proceed and recover from the guarantor after the moratorium is lifted, several questions arise to which answers are not yet forthcoming: (i) what ought to be the procedure for excluding such creditor from its position under the CIRP? (ii) whether the guarantor will be put in the shoes of the such creditor? (iii)  how will the claims of a guarantor (who has paid the guarantee amount) be treated in case the claims are finalized?

Effect on Standard Bank Guarantee Clauses

If the Allahabad High Court’s view is adopted, certain standard clauses in a bank guarantee stated below would carry a very diluted purpose if recovery proceedings against the guarantor are prohibited during moratorium.

1. “The Bank hereby irrevocably and unconditionally undertakes to pay to the Company on receipt of first written demand an amount not exceeding Rs. _________________/- (Rupees_____________________________ Only) on receipt of your intimation that the Contractor has for any reason failed to perform its obligation under the Contract including the warranty obligations/liabilities and any such demand made by you on the bank shall be paid without any demur, delay, reservation, contest, or protest, without your needing to prove or to show grounds or reasons for your demand or the sum specified therein.”

2. “The Bank hereby confirms that payment to you under this guarantee shall be made by the Bank, within 24 hours from receipt, at _____________, of demand/claim under this guarantee, without any demur, objection or dispute, or any reference whatsoever to the Contractor and/or to any third party, immediately upon receipt of claim, in writing. The Bank shall be primarily liable to you for any and all monies claimed by the you hereunder and shall not require you to proceed against or recover or exhaust or extinguish any other remedies or recourse you may have against any other property or person before payment is made in full by the Bank. The Company shall be entitled to make multiple demand/claims to the extent of guaranteed amount herein.”

Thus, any guarantees issued by a bank on behalf of a corporate debtor would be rendered infructuous for the term of the moratorium. This would prejudice the sanctity of the guarantees and discourage creditors from relying on guarantees as a safety measure for the recovery of their debts.

Conclusion

At present, the issue regarding the position and liability of guarantors under the guarantee during the moratorium period is somewhat open. However, it remains to be seen as to how this matter will finally put to rest by the Supreme Court or an amendment/ notification/ clarification by the Central Government to the Code.

– Milind Gaur

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1 comment

  • In the context of the Ramakrishnan NCLT, Chennai judgment you state:

    “However, as aforementioned, the creation of any such charge /encumbrance over the assets of the corporate debtor is prohibited until the time the moratorium is in force under section 14.”

    Would you agree that the Chennai bench ignored the fact that Section 14 prohibits the creation of an encumbrance (BY) the Corporate Debtor. (emphasis supplied)

    A possibility of a Guarantor creating a charge on the assets of the Corporate Debtor may not be prohibited under the moratorium, by a strict reading.

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